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Commodities Extremely Oversold

Commodities / Resources Investing Aug 20, 2008 - 10:53 AM GMT

By: Frank_Holmes

Commodities Best Financial Markets Analysis ArticleFaced with slowing global growth, macro investors began dumping commodities and commodity-related stocks, with small- and mid-cap stocks hurt the most. This commodities sell-off, which began in July and has continued into August, also corresponds to the long-term seasonal cycle in which prices for many commodities tend to bottom out in late summer before rebounding in the fall.


The unwinding of the long energy/short financials trade also has been a big driver of recent share price performance. The combination of rules to eliminate naked short selling on financial stocks, a backlash against higher commodity prices and potential government intervention aimed at speculators in the futures market, along with calls for pension funds to divest their commodity holdings, all converged in mid-July.

The recent decline in energy stocks was swift and severe and is likely overdone.

The fall in the price of oil futures from a high of $147 per barrel to $113 per barrel has been a headwind for the energy sector, but it seems investors have sold the sector without regard for price or value. Such a scenario usually presents attractive opportunities for long-term investors. 

To put this price decline in perspective, our review of historical trading data indicates that the 20 percent decline in the S&P 500 Energy Index over the last 60 trading days is the second-worst drop since 1998. You can see the steepness of this decline in the chart above.

A simple regression analysis of weekly data back 10 years indicates the S&P 500 Energy Index is priced at a 15 percent discount to the current oil futures strip – the largest discount in more than four years. The math says this is the time to put money to work in the energy sector. 

Many commodity stocks are now at oversold levels, as is clearly reflected in the oscillator charts for the S&P 500 Energy Index (above) and gold (below), which show a rolling 60-day rate of change going back 10 years. Based on this information, both stocks and commodities are due for a considerable rally. In addition, many energy stocks are trading at five to six times cash flow, which should be supportive from a valuation perspective.

The inverse relationship between gold and the dollar is widely known, and this relationship is especially important at inflection points. We believe that we are at one of those inflection points today. That can be seen in the visual below, which overlays the standard deviation oscillator of gold and the dollar, which are currently at opposite extremes. This is reminiscent of the spring of 2006, when gold was extended on the upside and the dollar had suffered a sharp decline. The dollar is at extreme levels versus many other currencies, including the Canadian dollar, Australian dollar, British pound and the euro.

We remain optimistic about the long-term picture for natural resources. However, the short term will remain volatile due to uncertainties in global currency exchange rates and future derivatives write-downs by investment banks and other financial institutions. We've seen that when the banks and brokerages have to raise capital to address their derivatives problems, it triggers abrupt liquidity squeezes that increase short-term volatility, especially in emerging markets and small-cap equities. The recent confrontation between Russia and Georgia has brought about heightened geopolitical tensions, which have contributed to volatility in currency markets and introduced significant uncertainty over the current world order.

On a positive note, China announced last week that it was changing policy to increase loan quotas. This is a significant shift in policy; in effect, China is refocusing on economic growth now that inflation there has trended lower. This type of policy action will continue to drive infrastructure spending, which in turn will drive demand for commodities. Another positive is the clear election-year signal by the U.S. government that it will do what is necessary to protect the financial sector and avoid a major recession, including an additional fiscal stimulus package in early 2009.

We believe this correction, while painful, is healthy and constructive for natural resource markets over the long term. Commodity supplies remain extremely tight, and as global population and emerging economies continue to grow, these trends will be supportive of commodity prices. The risk to this scenario would be major policy changes by the world's most populous countries that would slow infrastructure spending, which we continue to view as unlikely.

By Frank Holmes, CEO , U.S. Global Investors

Frank Holmes is CEO and chief investment officer at U.S. Global Investors , a Texas-based investment adviser that specializes in natural resources, emerging markets and global infrastructure. The company's 13 mutual funds include the Global Resources Fund (PSPFX) , Gold and Precious Metals Fund (USERX) and Global MegaTrends Fund (MEGAX) .

More timely commentary from Frank Holmes is available in his investment blog, “Frank Talk”: www.usfunds.com/franktalk .

Please consider carefully the fund's investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. Gold funds may be susceptible to adverse economic, political or regulatory developments due to concentrating in a single theme. The price of gold is subject to substantial price fluctuations over short periods of time and may be affected by unpredicted international monetary and political policies. We suggest investing no more than 5% to 10% of your portfolio in gold or gold stocks. The following securities mentioned in the article were held by one or more of U.S. Global Investors family of funds as of 12-31-07 : streetTRACKS Gold Trust.

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